Interest accrual rests on an assumption: that the borrower will pay. When a borrower stops paying, or the fund stops believing it will, continuing to book interest income would overstate what the fund is earning. Non-accrual status is how the accounts deal with that.
For fund accountants, moving a loan to non-accrual means reversing income and changing how every later receipt is booked. For BDC finance teams, auditors and LP-side analysts, non-accrual loans are one of the first places to look for credit problems in a portfolio. This lesson walks through the steps with an illustrative loan.
When a loan goes on non-accrual
A loan is placed on non-accrual status when the fund stops recognizing interest income on it. Policies differ by fund and accounting framework, but loans are commonly placed on non-accrual when:
- a payment of principal or interest is significantly past due; policies commonly use around 90 days, or
- full collection is in doubt, even if payments are still current, for example because the borrower is in a restructuring or its business has deteriorated sharply.
The second test is a judgment, made by the manager and reviewed by auditors. It can apply to PIK as well as cash interest: as lesson 2.2 noted, funds commonly stop accruing PIK they don't expect to collect. Some funds place only part of a loan's interest on non-accrual, such as the PIK portion, while continuing to accrue cash interest that's being paid.
Reversing accrued interest
The following example is illustrative and simplified. Kestrel Point Direct Lending Fund I holds a $30m term loan to a fictional borrower, Brookmere Home Services, at an all-in rate of 10%. To keep the numbers clean, each quarter's interest is a quarter of the annual amount (the loan is treated as if it paid on a 30/360 basis, not Actual/360 as in lesson 1.2):
$30,000,000 × 10% ÷ 4 = $750,000 a quarter.
Brookmere misses its March 31 payment. The fund had accrued that $750,000 as income in the first quarter, so it sits as interest receivable. During the second quarter, the fund keeps accruing, while the loan team works with the borrower. By June 30 the March payment is about 90 days past due, nothing has been paid, and the fund places the loan on non-accrual.
| Item | Amount |
|---|---|
| Q1 interest accrued, unpaid | $750,000 |
| Q2 interest accrued, unpaid | $750,000 |
| Interest receivable at June 30 | $1,500,000 |
| Reversed against interest income | ($1,500,000) |
Under many funds' policies, accrued but unpaid interest is reversed against interest income when a loan goes on non-accrual: the receivable is removed and income falls by the same amount. Here the fund's second-quarter income from Brookmere is $750,000 accrued less $1,500,000 reversed, or −$750,000. The first quarter's income is commonly not restated; the reversal falls in the period the decision is made. This is why a new non-accrual can reduce a fund's reported income in the quarter it happens.
From July 1, no further interest is accrued, although the borrower still legally owes it.
Applying cash received on non-accrual
Borrowers on non-accrual often still pay something. How the fund books it depends on its policy and on how collectible the loan looks:
- Cash basis: cash received as interest is recognized as interest income when received. Commonly used when the fund expects to recover the loan's cost.
- Cost recovery: all cash received is applied to reduce the loan's cost, and no income is recognized until cost has been recovered. Commonly used when recovering the loan's cost is itself in doubt.
Illustratively, Brookmere pays $600,000 in the third quarter:
| Method | Interest income | Loan cost after receipt |
|---|---|---|
| Cash basis | $600,000 | $30,000,000 |
| Cost recovery | $0 | $29,400,000 |
Operations and accounting need to agree on the method before the cash arrives, because the agent's notice (lesson 1.1) will still describe the payment as interest. The fund's own records may treat it differently.
Returning to accrual
A loan is commonly returned to accrual status when the borrower is current on its payments and the fund expects to collect all principal and interest. Many policies look for a period of sustained payments, or a restructuring that leaves the borrower able to service its new terms, rather than a single payment.
Interest reversed earlier is commonly not reinstated when the loan returns to accrual. How amounts applied to cost under cost recovery are treated afterwards depends on the fund's policy, which is one reason the accounting policy manual, and the auditor, matter here.
Why investors watch non-accrual rates
Funds commonly report the non-accrual rate in two ways: the non-accrual loans' amortized cost as a share of the whole portfolio's cost, and their fair value as a share of the portfolio's fair value.
Illustratively, suppose a fund's loans have a cost of $600m and a fair value of $570m, and Brookmere, with a cost of $30m, is marked at a fair value of $18m:
| Measure | Calculation | Non-accrual rate |
|---|---|---|
| At cost | $30m ÷ $600m | 5.00% |
| At fair value | $18m ÷ $570m | 3.16% |
The fair value rate is lower because non-accrual loans are usually marked down. The gap between the two gives a sense of how much value the fund thinks has been lost on them.
Analysts watch these rates because non-accrual loans produce no reported income, so a rising rate can mean lower income ahead and possible losses on principal. They also compare the trend over time, and look alongside it at loans moved to PIK (lesson 2.2), which can show stress before a loan reaches non-accrual.
Key terms
- Non-accrual status: A loan on which the fund has stopped recognizing interest income.
- Reversal of accrued interest: Removing interest recorded but not paid, and reducing income by the same amount.
- Cash basis: Recognizing interest income on a non-accrual loan only when cash is received.
- Cost recovery method: Applying all cash received to reduce a loan's cost, with no income recognized until cost is recovered.
- Non-accrual rate: Non-accrual loans as a share of the portfolio, measured at cost or at fair value.
Key takeaways
- Loans are commonly placed on non-accrual when payment is significantly past due (often around 90 days) or full collection is in doubt.
- Accrued but unpaid interest is commonly reversed against income, which can reduce income in the quarter a loan goes on non-accrual.
- On non-accrual, cash received is recognized as income (cash basis) or applied to reduce cost (cost recovery), depending on policy and collectibility.
- A loan commonly returns to accrual when payments are current and full collection is expected.
- Non-accrual rates at cost and at fair value are key credit signals; the gap reflects markdowns on those loans.
This lesson is for educational purposes only and is not investment advice.